Monte Carlo and the 4% Rule: Do I Have Enough to Retire?
The question: Do I have Enough to Retire is one most face at some point in life.
While retirement is about much more than money, if you don’t have enough, you might not get a chance to enjoy the better parts of it!
Talking strictly numbers, of course the most important number is how much to spend in retirement? After all, you can outspend any nest egg if you try hard enough!
After you know how much you need, the next step is to look backwards and look forward to see if you have enough to retire.
Let’s look backwards (the 4% Rule) and look forwards (Monte Carlo) and determine: do I have enough to retire?
Do I Have Enough to Retire?
While attempting to answer the question “do I have enough to retire,” one may look backwards via the 4% Rule or look forwards via Monte Carlo projections.
Looking Backwards (The 4% Rule)
I have written quite a bit about the 4% rule both in normal and early retirement. See:
- The 4% Rule in Action
- The Safe Withdrawal Rule (or, why the 4% Rule doesn’t work)
- What is the Safe Withdrawal Rate in Early Retirement?
In summary, if history is any guide, you can take an inflation adjusted 4% of your broadly diversified portfolio and not run out of money over 30 years.
I say this is looking backwards because it uses historical returns. We know the past: stock, bond and cash returns, as well as inflation, are known. Looking backwards informs us: over 30-year rolling periods of time, what initial withdrawal rate almost never fails.
Looking Forward (Monte Carlo)
Monte Carlo projections are a bit like magic. Add a bit of this and a side of that, and the result is pretty unreliable. The only thing we know about future expectations is that we are going to be wrong!
Please understand, Monte Carlo provides a number that can be very unreliable depending on assumptions. That is, I really don’t like Monte Carlo. It is only really useful as a relative, comparative tool. That is, if this is “your number,” then changing this assumption does that to the success odds.
Looking forward, that is, using sets of random future returns, Monte Carlo let’s us run multiple iterations of possible returns to determine how a given asset allocation performs. A dash of this and a bit of that… and you have the future!
Here are some references:
Next, let’s look at some examples of the 4% Rule and Monte Carlo to see if I have enough to retire.
Examples: Do I Have Enough to Retire?
Let’s start with a 65-year-old couple.
Above are the Monte Carlo odds that their 1.6M nest egg provides enough to retire and live to age 90.
On the left, they plan to spend $7k a month, which is an 6% withdrawal rate on the portfolio (which doesn’t include non-investment assets). Odds are 95% and they will, on average, end up with $1.15M at age 90.
On the right, they plan to spend 8k a month instead, which is a 7.5% withdrawal rate. Odds and amount remaining are less.
Note we can make Monte Carlo Odds go from 95% all the way down to 71% just by increasing spending by 12k a year. That is a 0.075% increase in spending per year!
Understand this about Monte Carlo: you can pretty much make the odds whatever you please by small changes in spending or return assumptions over time.
As a note, their home is included in their net worth, which is why the withdrawal rate on the portfolio is higher than the withdrawal rate on their total net worth.
Next, let’s look at their withdrawal rate.
Above, they have a 6% withdrawal rate after social security and including RMDs.
The message here is: a 6% withdrawal rate is fine as long as you are over the hump regarding sequence of returns risk.
These folks have a nice social security in addition to a pension. They have less then 30 years to worry about; they can withdrawal more than 4% very safely!
In summary: Monte Carlo odds change drastically depending on how much you spend, and withdrawal rate can be higher than 4%.
Let’s look at another example.
Do I have Enough to Retire Second Example
Again, let’s have a look at the future with Monte Carlo and the past with the Safe withdrawal rate.
In this example, we have a 50-year old conservative couple with a 50/50 portfolio; on the right, note they have a 58% chance of success.
Because this Monte Carlo software is built to show of the “ability” of a financial planner, look what happens when we make their portfolio 90/10 and “broadly diversified.” It goes all the way up to 86%, and remarkably, they have 10x more money at the “end” of the plan.
“Give me your money, folks, and I’ll increase your odds of success!” Pretty good marketing tool, this Monte Carlo, eh?
Just by toggling the aggressiveness of the asset allocation in the program, you can vastly change Monte Carlo odds.
What? Look above; a 3% withdrawal rate but the Monte Carlo above is only 58?
Well here, this couple has minimal amount of social security and no pension. And they are starting at age 50 instead of the first couple starting at age 65. The withdrawal rate seems absurdly low when you get to RMD age, but the Monte Carlo odds kinda suck. Here, they have low odds due to lack of annuity income (pension and social security), and a long time for the portfolio to survive.
Summary: Do I have Enough to Retire?
In summary, Monte Carlo can be very sensitive to asset allocation (as the returns are random, but there is always an equity premium over time), to the length of the plan (it really doesn’t “like” early retirement), and to small changes in yearly funding requirements.
Withdrawal rate and the 4% rule of thumb can be off depending on type of assets and product allocation. (Product Allocation is the best mix of products and portfolio in retirement to mitigate known retirement risks)
From these examples, I hope you see retirement planning is more of an art rather than a science. Yes, there are a lot of moving parts, and they can greatly affect your “number.”
Moving parts to consider:
- Social Security
- Pensions and should I get an annuity?
- Order of withdrawals and withdrawal strategy
- Retirement Glidepath and De-Risking
- Sequence of Returns Risk
- The Tax Planning Window
- And Don’t forget, finally, partial Roth conversions to control your taxes!
So, Do I have Enough to Retire?
In the end, when you ask yourself “Do I have Enough to Retire,” you are going to have to take a leap of faith. Understanding the risks in retirement is important, but the best laid plans often go astray. The best advice: be prepared, and be flexible!
Do I Have Enough To Retire? Understand the numbers and have a plan! Here is a retirement checklist for physicians to get started!